Credit rating downgrades: 5 things to know

The recent rating downgrades of IDBI Bank and Reliance Communications by credit raters have made headlines with both counters down by 22% and 40%, respectivelyYogita Khatri | ET Bureau | June 05, 2017, 09:38 IST

The recent rating downgrades of IDBI Bank and Reliance Communications by credit raters have made headlines with both counters down by 22% and 40%, respectively , over the last one month. A downgrade, simply put, is a negative change in the rating of a company's debt security. Here are five things you should know about downgrades to be better informed and prepared.

WHY DO COMPANIES FACE DOWNGRADES?

One of the key reasons companies face credit rating downgrades is their deteriorating finances, usually high debt levels. It indicates that the company may not be able to service its debt at an expected pace or may even default in some cases. IDBI Bank has recently faced a series of downgrades by various credit rating agencies. Icra, for one, downgraded IDBI Bank to `IND AA ', Outlook Negative due to weakening of asset quality that led to the bank reporting high losses.

“Despite the capital infusion by the government in FY2017, the regulatory capital requirement levels for core equity were breached,“ says Karthik Srinivasan, senior vice-president, Icra. “While the ownership structure provides comfort, the risk on additional tier-I bonds has increased where as per the terms of the bond, the bank may not be able to service the coupon in case it remains in breach of the regulatory capital requirements,“ he adds.

Typically , high debt levels with limited improvements in cash flows lead companies to downgrades. Not only banks, this is true for capital-intensive and commodity-driven sectors like thermal power, steel, construction, infrastructure and mid-sized telecom entities, say experts. “Taking the eye off the key ratios such as incremental return on capital employed or incremental return on assets for investment decisions and not initiating action to recover dues in time could also lead to downgrades,“ says Deepak Jasani, head-retail research, HDFC Securities.

HOW DOES IT IMPACT COMPANIES?

Rating downgrades usually hamper the company's ability to borrow more at fine terms. Lenders may hesitate from giving companies more debt or may not even roll-over existing debt.

The cost of borrowing also increases for the companies. This is because investors will seek higher returns for the additional risks that they might take up. “Accordingly , the companies will have to improve their operational and financial matrices to get funds from investors at more attractive rates,“ says Srinivasan. If the compa ny doesn't take speedy corrective action, it could lead to further downgrades.

HOW DOES IT IMPACT YOU AS INVESTOR?

Rating downgrades usually result in a knee-jerk reaction to the company's stock prices, which could impact equity investments in the short run.Even your debt mutual fund investments could be impacted. “Investors in debt instruments that witness sudden and sharp downgrades will be faced with losses as their investments will need to be marked down due to the change in prices on account of the downgrade,“ says Somasekhar Vemuri, senior director, Crisil Ratings.

WHAT SHOULD YOU DO?

A rating downgrade is an alarm bell for you to take corrective action if any.However, do not be over-concerned with one downgrade. “A series of downgrades is a reason to be concerned for an investor rather than a single downgrade,“ says Jasani.Therefore, pay close attention to all recent ratings and also future outlook which is given in the rating notes by agencies. All long-term ratings from Crisil carry an outlook which gives the direction in which the rating is expected to move in the next 12-18 months.

For corrective action, do listen to the explanation provided by the management in response to the downgrade and take a call on whether the promises made by the management to correct the situation are likely to be met in the time mentioned. If you think the measures are unrealistic, you may exit once the prices recover.

HOW TO KNOW OF MORE DOWNGRADES?

“If the rating outlook is negative, then typically the ratings are more likely to be downgraded,“ says Srinivasan.Hence, you may limiting your exposure to such investments directly or indirectly . You should also do some research at an individual level. For banks, do look at its non-performing asset levels or bad loans over quarters and years. While in the case of a company , pay close attention to its debt-equity ratio and the interest coverage ratio (ICR). If these ratios are poor and show little signs of improvement, you should start getting worried.

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